Business Interest Expense Limitations

Melissa Lanigan, CPA (May, 2018)

The Tax Cuts and Jobs Act made major changes to just about every aspect of the tax code.  No one taxpayer (individual, corporation or sole proprietor) was unaffected by the changes.  Some of the changes will have a positive impact on taxpayers, i.e. lower tax rates, and some of the changes will not be as positive, i.e. eliminated or reduced deductions.

One deduction changed by the Tax Cuts and Jobs Act was the business interest deduction.  Under Pre-Act law, effective through December 31, 2017, interest paid or accrued by a business was deductible as an ordinary business expense when computing taxable income.  Under new tax law, effective for tax years beginning January 1, 2018 and later, every corporation, partnership and sole proprietorship, is now subject to limitations of the interest deduction of up to 30% of the business's adjusted taxable income.

The deduction allowed for business interest cannot exceed the sum of:

1)      the taxpayer's business interest income for the year,

2)      30% of the taxpayer's adjusted taxable income for the tax year, plus

3)      the taxpayer's floor plan financing interest for the tax year (Side note: Floor plan financing is certain interest paid by vehicle dealers.  This interest is fully deductible under the new law.  Although, property that is used in the trade or business that has floor planning debt, is excluded from 100% bonus depreciation if the interest expenses is fully deducted, i.e. you can't double dip deductions). 

For example, consider these facts.  A business has $100,000 of adjusted taxable income (explained later), $2,000 of business interest income, and $12,000 of business interest expense.  The business can deduct 100% of the $12,000 business interest because this is less than $32,000, the sum of $2,000 of interest income and 30% of its adjustable taxable income (30%*100,000=$30,000).

Another example of the business interest expense limitation; same facts as above, except the business only has $10,000 of adjusted taxable income.  The business interest deduction is limited to $5,000.  The limited deduction is calculated as follows: $2,000 of business interest plus 30% of adjustable taxable income (30%*10,000=$3,000).  The remaining $7,000 of disallowed interest expense is carried forward to future tax years indefinitely.  Yes, you read that correctly, even though you can't deduct the interest expense in the year incurred, the disallowed interest can be deducted in future years.

Applying the business interest limitation is similar for both S Corporations and partnerships.  The limitation is applied at the corporation/partnership level.  The deduction for business interest is taken into account in determining the corporation's or partnership's taxable income or loss before allocating income or loss to each partner or shareholder based ownership percentage. 

For example, ABC partnership is owned 50/50 by 2 individuals, with $200 of income and $60 of interest expense.  ABC is able to deduct $60 of interest expense up to 30% of adjustable taxable income or $200*30%=$60, and reports ordinary business income of $140.  Each partner's distributive share of income is $70.  

In the event interest expense is greater than 30% of adjusted taxable income, the excess business interest is allocated to each partner, rather than carried forward at the partnership level.  The partner may deduct its share of excess partnership interest in future years, but only against excess taxable income from the same partnership in which the carryforward interest was generated.   

Adjusted taxable income for purposes of calculating the business interest limitation, is calculated starting with taxable income and excludes:

  • income, gains, deduction, or losses that are not applicable to the trade or business,
  • business interest expense,
  • business interest income,
  • net operating loss (NOL) deduction,
  • the amount of any qualified business income deduction (the new 20% deduction added by Tax Cuts and Jobs Act), and
  • depreciation, amortization or depletion deduction.

Luckily, if you are a small business, there is an exception in which the business interest limitation would not apply.  The business interest limitation does not apply if the company meets the $25 million gross receipts test for any tax year.  To apply this test for years ended 2018, calculate the average gross receipts for the prior 3 year ends, i.e. 2015, 2016 and 2017, if less than $25 million, the interest limitation does not apply.  The calculation and limitation is applied the same for all types of entities, corporation, partnership and sole proprietorship.

Generally, the business interest limitation does not apply to certain other trades or business, including:

  • Employees - Performing services as an employee is not a trade or business for purposes of the business interest limitation, therefore, an employee's wages are not counted in the taxpayer's AGI for purposes of determining the limitation
  • Electing Real Property Trade or Business
  • Electing Farming Property Trade or Business
  • Regulated Public Utility

As you can see, the Tax Cuts and Jobs Act made a simple deduction of business interest expense a little more complicated, but fortunately, with the small business exception there are many businesses the limitation does not apply to.  In cases where this does apply, please feel free to contact your Dermody, Burke & Brown advisor to discuss this and all other tax matters further. 

 

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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